How To Trade in Derivatives Market in India?

Derivatives, a centuries-old asset class has captured the highest interest from investors worldwide. The derivatives market has experienced tremendous growth in recent decades and plays an important role in many economies. And, while derivatives offer immense potential for profit (which explains their popularity), their high-risk nature often leaves investors cautious. However, despite the inherent risks, it is remarkable to note that in 2023, India dominated the derivatives market, accounting for over 78% of equity options contracts traded!

One of the key players in the Indian derivatives market is the National Stock Exchange of India (NSE). The NSE made its foray into derivatives trading in 2000 with the introduction of index futures based on the widely followed Nifty 50 benchmark index. Building on this success, the NSE expanded its offerings by launching trading in index options (again based on Nifty 50) in 2001. The exchange further enhanced its derivatives market in 2001 again by introducing options on individual securities. 

So, how exactly do derivatives work? Take a guess from the name ‘derivative.’ Think of it as a contract or agreement where value is ‘derived’ from an asset class—stocks, commodities, currency, almost anything. The whole use case of derivatives is that they enable investors to speculate on price movements and manage risks associated with different assets without owning them outright. 

But what do ‘options’, ‘futures’, or an ‘underlying asset’ mean? In this blog, we break down derivatives, their trading, and types (and all the lingos, too). As a bonus, we will also cover how you can trade in the derivatives market! 

Let’s dive right in. 

What Are Derivatives in Stock Market?

Derivatives are complex financial instruments that derive their value from an underlying asset. In simple terms, a derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index, or security. This underlying asset can be almost anything, such as a stock, bond, commodity, currency, interest rate, or even market index. For example, a derivative contract could be based on the price of gold or stock, the interest rate of government bonds, and more.  

At the core, the concept of derivatives is this: It allows investors to participate or bet on the underlying asset's price movement without actually owning it! For example, you can bet that the price of oil will rise in the next three months using a derivative contract without actually buying barrels of oil. Do you see how, with derivatives, you can still make profits or take advantage of price movements without investing in the asset literally? 

Derivatives are largely used for hedging purposes to reduce risk or for speculation to profit from price movements, as mentioned above. While derivatives seem complex, they help complete markets by allowing various participants to manage risk and capitalise on views. There are various types of derivative contracts that serve different functions in the market. The most common are futures, options, swaps and forwards. We will explore these in detail below. 

Different Types of Derivatives Contracts in Stock Market

Derivatives that derive their value from underlying assets are majorly of four types, as explained below – 

• Futures:

Among the array of equity derivatives, futures stand as one of the most common instruments. Futures contracts are standardised agreements wherein parties agree to buy or sell a specific quantity of an underlying asset at a predetermined rate and date. Both parties here are obligated to execute their contracts. 

Future contracts are traded on exchanges with their value marked day-to-day i.e they are settled daily at end of the day.  Also, they are regulated by government appointed bodies and enjoy high liquidity. Let’s take an example to understand futures. Consider a trader who purchased future contracts for 100 shares of a particular company at Rs.200 per share with a  maturity of one month. If the price of the share rises to Rs.220 at the end of the month, the trader can sell the contract and pocket the profit.

• Options:

Options provide another avenue for investors, offering the right but not the obligation to buy or sell an asset at a predetermined price within a specified time frame. Options market is basically classified into American options and European options. The American options can be exercised anytime but European options can be exercised only on the expiry date. All options in the Indian market are of the European style. 

Now, there are two types of options – call and put. Call options grant the holder the right to buy, while put options allow the holder to sell. Call options are bought when traders are bullish on price movement and puts are bought when the traders are bearish on a certain stock. 

Let’s take a call option as an example to understand this better. Imagine an investor who buys a call option for 100 shares of a company at a strike price of Rs.250 per share. If the market price surpasses Rs.250 before the option expires, the investor can exercise the option and buy the shares at the predetermined price, thus profiting from the price difference. We will learn in detail about options and more in the next chapter. 

Forwards:

Forward contracts are customisable derivative contract between two parties to exchange an asset at an agreed price and date. Unlike standardised futures, forwards don’t require initial margins, are tailored to the needs of the counterparties and typically have low liquidity. Settlement happens at a date decided by the parties and is OTC (over the counter) in nature. 

Forwards carry high counterparty risk because they are not regulated by government bodies or any central agencies. If one party fails to fulfil the agreement, it will pose a default risk to the other. Also, the lack of regulatory oversight makes forwards less transparent and prone to default. 

Here’s an example. Suppose two investors agree to a forward contract to exchange 200 shares at Rs.300 per share after six months. One party here believes the price will rise in the future and the other party believes the opposite. On the date of the settlement, regardless of where the stock price is, both parties will need to honour their contracts. This arrangement enables the parties to hedge against price fluctuations and lock in future prices.

• Swaps:

Swaps are another derivative type in which two parties exchange cash flows or liabilities based on different financial instruments. Unlike exchange-traded derivatives, swaps are traded over the counter, meaning they’re not regulated by any centralised authority. 

Typically, counterparties in swaps are large financial institutions due to the high risks involved. For instance, think of interest rate swaps. Here, two parties can enter a swap agreement whereby one type of interest is exchanged with another type of interest to make profits or hedge risk. However, swaps carry high risk, and both parties must carefully assess their requirements before entering into such an agreement. 

What Is Derivative Trading?

Trading in the derivative markets or derivative trading simply refers to buying and selling existing derivative contracts between market participants. When a new derivative contract is introduced, there needs to be a seller and a buyer to create liquidity in the market. After the initial transaction, the contracts can change hands multiple times until expiration. 

For example, when an investor buys a option derivative contract to lock in the future price of, say a stock, they are entering into an agreement with the seller. Post that, either party is free to offset or unwind that position by finding another buyer or seller in the market. Likewise, the initial seller can now choose to take an offsetting position and sell another option contract to reduce their net risk exposure. 

This process of exchanging derivative contracts allows risk transfer between parties and the continuous discovery of fair prices. Derivative exchanges facilitate trading by bringing together buyers and sellers on central platforms. In India, equity derivatives are traded on the NSE (National Stock Exchange of India) and BSE (Bombay Stock Exchange). 

Brokers help clients trade derivatives contracts according to their risk appetite and investment objectives. Professional traders may arbitrage between derivative and cash markets to earn small profits. But remember this – Derivatives trading is extremely risk-prone. You may, in fact, end up eroding your entire capital. It is thus imperative that you understand the ins and outs of this asset class thoroughly before you trade in them.

The question you may now have in mind could be this – How to trade derivatives? Well, let’s explore this in detail below. 

How to Trade in the Derivatives Market?/Steps to Trade in Derivatives

Before you start trading derivatives, make sure you have a Demat account. Think of it like an e-safe for your securities. Next, you will need to open a trading account that is linked to your Demat account. This trading account can be treated as your identity in the markets. 

Now, when it comes to derivative trading, there’s a key thing called margin maintenance. Unlike regular trading, where you pay the full price for stocks, in derivatives, you only need to deposit a part of the value with the exchange. This deposit, known as margin money, has two parts – initial and exposure margins. These margins are required by markets to ensure participants remain faithful to their commitments, mitigate risk, and avoid fraud. 

Now that you understand terms like Demat, trading account, and margins, here’s how you can trade derivatives. 

1. Begin with thorough research. Remember that this is the most important step in navigating the derivatives market. The research should help you devise a strategy that is ideally distinct from how you trade regular stocks.
2. Once your research is complete, activate your trading account (to support derivative trading) and consult your broker. Your broker will place orders on your behalf, either over the phone or online.  
3. As mentioned above, derivatives are extremely risky. So select stocks and contracts based on your risk appetite and other technical factors like available funds, margin requirements, underlying stock prices, and contract prices. 

Lastly, based on market movement and your strategy, you can decide whether to wait for the contract to expire or settle the trade earlier. 

With this, we draw the curtain on this chapter. In the next chapter, we will explore one type of derivative in great depth: Options.